The Irish “bad bank” and its implications for it and the UK

31st March 2010 by Shaun Richards

After yesterday’s news on economic growth which might have put a mild smile on UK faces came an announcement from the Irish government which has significant implications which will also echo across the Irish Sea. Before I Leave the subject of our growth figures I would like to remind everyone that recessions are often quite substantially revised (down) as time passes. For example the recession of the early 1990s was in the original estimates thought to involve a fall in Gross Domestic Product (GDP) of 4.2% which was in time revised down to a fall of half that or 2.1%. So we will see further falls in the depth of the recession of 2008/09 as time goes by if it follows the usual pattern, and if this happens we can expect our authorities to try to give the credit to their Quantitative Easing(QE) Project. As I am sure you are aware there was no QE in the early 1990s recession, please remember that.

Ireland

Before the credit crunch hit Ireland was essentially boom town and much of the boom came from the property sector, particularly commercial property. Here there are some similarities to Greece as Euro zone membership appeared to be almost an elixir. Her banking sector also grew domestically but also grew abroad for example Bank of Ireland bought the Bristol and West building society and became the supplier of savings products to the UK Post Office.

Then came the credit crunch and over-exposure to the property and bank sectors left Ireland’s economic strategy in tatters and Euro zone membership was suddenly no longer an elixir. Furthermore the crisis that is Iceland had similarities to Ireland’s position in terms of an over-exposure to banking (rather curiously this may well have been best expressed by the Scottish National Party’s talk of “an arc of prosperity”). So the Irish government had to provide support for her banks and also had to announce quite a severe austerity budget (total reduction of around 6% of GDP) in an attempt to re-gain control over a rapidly escalating fiscal deficit. It was a sign I felt of desperation when Ireland guaranteed all banking deposits for two years which ends on the 28th September 2010. However to their credit they have attempted to address their problems and they have had some success. But yesterday showed the depth of the problems still ahead.

The Problem

1. An under-capitalised banking sector

2. Commercial Property loans made by the banking sector where the property used as an asset against the loan has fallen in price often substantially.

Of course these two factors combine. The situation meant that Anglo-Irish Bank was in such a mess nationalisation looked likely and Allied Irish Bank and Bank of Ireland were going to either have to make substantial asset sales or raise more capital or both. Just to look at one bank the Irish Times estimated that Bank of Ireland needs 2.5 billion Euros of capital. Having dealt with them in the past I see this as a sad development. There was talk that there would have to be a haircut on all property assets in the region of 30-40%.

The Solution

Ireland has created what elsewhere has been called a “bad bank” to take over the underperforming loans and it has called it National Asset Management Agency (NAMA). However before it takes them over it will apply a “haircut” to them which means it will take them over at what it thinks they are worth not what they are in the various banks books. The initial haircut on the first 16 billion Euros of loans will be at an average of 47% with the Irish National Building Society looking the most reckless lender. Put another way this is a write-down for Irish banks of 7.52 billion Euros. In total it will eventually takeover around 81 billion Euros of loans.

NB

The geographical breakdown is important to us in the UK as 21% or 17 billion Euros is here and it would appear Northern Ireland has another 6% (this way of counting is I would imagine a legacy of the obvious territorial issues). Ireland is 67%.

The banks have a massive capital shortfall from this and just to add to it new capital requirements were brought in of 8% tier one capital by the end of this year. So Bank of Ireland turned out to need 2.7 billion Euros and Anglo-Irish Bank needed nationalising as there was no hope of her raising over 7 billion Euros. The state will provide the necessary capital for Anglo-Irish Bank and will also nationalise EBS building society and the Irish Nationwide building society. Bank of Ireland has announced new capital raising plans this morning. All in all the Irish banking sector will soak up 20 billion Eurosinitially and more like 30 billion eventually much of which the taxpayer will have to provide.

Comment

Ireland deserves credit for the way she has tackled the financial crisis. She has responded decisively and in a timely fashion. Unfortunately the scale of the mistakes made in property lending were very large when compared with the size of her economy. If NAMA ends up taking over the 81 billion Euros of bad loans that is expected this is equivalent to half of one years economic output for Ireland. In the words of her Finance Minister this is “truly shocking” and “Our worst fears have been surpassed.”

In the short-term I feel that markets will review these moves favourably for the reasons I have described above. But as time goes by she is now very vulnerable to any adverse shocks as the Irish taxpayer is in credit card terminology pretty much maxed to the limit in my view. There is a clear danger of a “vicious circle” of bad news developing as time goes by.

Implications for the UK

There are clear implications for us as the scale of the lending by Irish banks in the UK was high. If we take our definition of the UK then NAMA will own around nearly 22 billion Euros of UK property assets. Sooner or later it will want to sell them.

Added to this is a report from DTZ which has estimated a possible debt finance shortfall in Europe over the next two years. You may not be surprised to read that the majority of this is in the UK and Spain. It estimates that the UK has a prospective shortfall of 42 billion Euros. Now these calculations depend on quite a few things but when added to the fact that the previous paragraph tell us there is at least one sizeable seller around…..

UK Banks

In terms of property exposure it is estimated that Lloyds Banking Group has £67 billion of commercial property loans on its books with RBS having some £43 billion, our other main banks have been more conservative with only £25 billion between them according to NCB Stockbrokers. There have been some small sales of these assets but in essence we have a situation like the residential property market where prices have recovered but volume is low. Many wise investors regard low volume as a warning signal. Another warning signal is that money has again flowed into commercial property investment funds (sadly as a group the retail investor is usually a reverse indicator).

Although they do not admit it our banks would like to sell much of their commercial property holdings. In the case of Lloyds and RBS it would get the taxpayer off their back. But with NAMA such a prospective large property seller in the UK before we even get to them then an enormous amount of property buying will be required. There are large dangers ahead for our two part-nationalised banks and our commercial property sector and I feel that any attempted sale of our holdings should be delayed. It is plain by the way that UKFI (the company which holds our bank stakes) is in effect misrepresenting the taxpayers purchase price that someone in authority is putting plans in place for a future sale. I think a sale can only be made in the near future by also misrepresenting the state of our commercial property market. In short more political fudge of which we have had plenty recently.

17 thoughts on “The Irish “bad bank” and its implications for it and the UK”

  1. Mac says:

    The commercial sector implications could easily ramp up pressure on the domestic house sector and lead to more aggressive action taken by the banks with regard to defaulters. That would in my view already be the case if it wasn’t for the fact that HMG hold a lot of that domestic paper and we are about to see the poll booths opening. Once the stake held by HMG is back in the private sector that will inevitably force banks to re-examine their loan books and redress the imbalance they find.

  2. andy of yarm says:

    Outside the M25 there are massive amounts of new build plate glass offices with no tenant,or realistic hope of. Much of this speculative rubbish sits now on Lloyd’s books. The harsh truth is the site is often worth not much more than value.Indeed it may end up cheaper to to knock the structure down to avoid property taxes.

    The Irish has come clean as to the clearing price of this stuff in their write down. Two years on in the UK we are still in denial.

  3. andy of yarm says:

    Apologies on line 4 I intended to write “not much more than LAND value”

  4. Drf says:

    “The state will provide the necessary capital for Anglo-Irish Bank and will also nationalise EBS building society and the Irish Nationwide building society.” Surely this should refer to Allied Irish Bank and BoI which seem to be the banks which the Irish government is salvaging at present. Anglo-Irish Bank was salvaged by being nationalised by the Irish government last year?

    The Irish government evidently is now going to inject another €8.3billion into Anglo-Irish bank’s balance sheet, plus a further possible €10billion for future losses.

    See:http://www.dailymail.co.uk/money/article-1262539/Bank-Ireland-posts-3bn-loss-state-approves-new-bailout.html

    1. Hi DRF
      The state is likely to end up as a majority owner of all the main Irish banks except for Bank of Ireland and end up as the main supplier of funds to the building societies mentioned. So apart from Bank of Ireland we are likely to see de facto nationalisation of much of the Irish banking sector. The “and will” in the above sentence wasn’t meant to imply that Anglo Irish was going to be nationalised! I should have put de facto after the and will.

  5. Johan_Heuvel says:

    That does not paint a pretty picture, not a pretty picture at all. Also considering the demand shifts that are upon us soon, as the baby boomers retire. which I suspect are not in the official numbers either.
    What will happen to home prices in an excessive supply situation combined with inflated prices? Can we get a value undershoot as the system rebalances?

    Shaun, I am currently in California and I was reading some rather disturbing stuff on state debt levels in the USA in the New york times.
    Here is a link: http://www.nytimes.com/2010/03/30/business/economy/30states.html?pagewanted=2&sq=state debt woes&st=cse&scp=1

    Basically, some states took the pension liabilities of the books and already counted the health care reform tax dollars to fix the books. California, basically issued IOU’s last year to keep afloat. Estimates were that state debt actually accounts for 5.17 trillion dollars instead of the official 1.94 trillion dollars. That is a rather large number compared to the USA 50 state GDP.

    This quote was in other rather disturbing New York local news:
    “ALBANY — Gov. David A. Paterson ordered the delay of $2.1 billion in aid payments to local school districts on Tuesday, saying the state did not have enough cash to pay bills and still end the fiscal year with its budget balanced. ”

    “The sheer size of the state’s unpaid bills underscore an unsettling truth: New York is living hand-to-mouth, the state’s solvency at risk day to day. ”

    Do you have any insight on how this may play out? What will happen if several USA states start to default at the same time?

    1. Hi Johan
      I bet the weather is much better than here! We have switched to British Summer Time but apparently no-one told the weather. Thanks for the link there are a few states in trouble and a friend sent me some stuff on New Jersey yesterday. At the last one or two auctions the US Treasury has found it harder to sell its bonds and the victory for Obama on healthcare whilst a political victory will press deficits higher. So the pressure is building but America still sees herself as different from Europe and here is a quote from an American blog on Europe’s problems “If this was happening in the US, Bernanke would’ve squashed this bug a week ago”. One thing that has happened and is disturbing me more is the canary in the coalmine which has now spread to 7 year maturities.

      1. Johan_Heuvel says:

        Hi Shaun,

        yes that canary is actually rather strange. Does this imply that AAA rated governments are actually not really AAA? Has the government rating landscape actually shifted downward in its entirity without changing the ratings themselves? So what is called AAA now, would have been called AA or even A a decade ago?

        I’m not familiar with the US system, so I was wondering what would happen if for example New York defaults on its obligations, who will take the hit? Will the a Federal entity cover the debt, or will the people holding new york debt simply loose their money overnight?

        1. I think that your first paragraph is true that AAA has less value than it did, although to my mind much of that is due to the fact that any logical person should have much less faith in the ratings agencies after their succession of failures and mistakes. They also tend to act after the event…

          I have taken a look at when California looked like she might default in 2009. The examples of states defaulting given were from the 1840s so no-one seems entirely clear exactly what would happen now. Here is a quote from a professor at California’s Centre for Economic Research
          “Unfortunately, a formal bankruptcy is not the likely scenario. There is no provision for it in the law. Consequently, absent framework and rules of bankruptcy, the eventual default is likely to be very messy, contentious and political”. So the truth is it appears unclear unless there is an American political law specialist reading this web site and can tell us otherwise. I worked through a period in the UK when everybody thought local council debt was guaranteed by the government but when some swaps deals failed no bail out came, this would have been roundabout 20 or so years ago.

          1. Mr.Kowalski says:

            Under California law (as I understand it) the debt gets paid first, then everything else second. A few commentators have said that California debt is a screaming buy ! My understanding is that states cannot go bankrupt, though local municipals (cities,counties) can. California isn’t the only one; my understanding is that Obama’s home state of Illinois is in worse shape, with a $22 billion hole in their $38 billion budget. Anyways, here’s my article on the muni bond catastrophe; in it is a link to an article written by a Harvard law professor on the mess :

            http://themeanoldinvestor.blogspot.com/2009/11/problem-with-muni-bonds.html

          2. Johan_Heuvel says:

            Hi Mr.Kowalski,

            Thanks for that link. Your example of a city in the great depression finally being allowed to default is verry interesting.
            What will happen if California cannot pay its debt? If they are not allowed to default. Are they then forced to raise taxes dramatically or fire employees? What taxation tools does the state of California have to raise its income? And are those tools bounded by legal or federal limits? Is there for example a legal limit on the percentage of property and sales tax?

          3. Johan_Heuvel says:

            Hi Shaun,

            Using the links of the articles of Mr.Kowalski I finally found some figures on the matter. And to be honest they look horrific. I am not sure how reliable these stats are though. Here is the link: http://www.stateline.org/live/details/story?contentId=436547
            Some states have a huge budget gap due to falling income and increased expenditure. That combined with the afore mentioned cooking of the books: Not acounting for pension liabilities and including health care reform dollars of the future, paying bills with IOU’s, makes me afraid of the actual numbers.

  6. Mickalus says:

    “Johan_Heuvel Says:
    March 31, 2010 at 5:39 pm

    That does not paint a pretty picture, not a pretty picture at all. Also considering the demand shifts that are upon us soon, as the baby boomers retire. which I suspect are not in the official numbers either.”

    Hi notayesman, Johan,

    One big plus in Ireland in light of Johan’s comment is our demographic structure. As the boom collapsed, immigration held more or less firm, and the nation entered a baby boom (need for comfort, probably). Hopefully the problems you allude to with the retirement of the babyboomers can be avoided.

    Thanks for an interesting and well-balanced post. AngloIrish’s losses are truly staggering, and illustrate the absolute lack of regulation and governance that permeated the financial sector. AIB is in a mess, but fortunately has valuable US and Polish assets it must now sell to recoup some of it’s losses.

    The appointment since of new Financial regulator, who has taken to wielding his powers extensively and aggressively is to be hugely welcomed.

    1. andy of yarm says:

      Certainly from a UK standpoint I can only applaud the Irish Govt for grasping the nettle.They have have sent two important signals to the markets
      (i) Immediate painful action to try to bring the spending deficit under control
      (ii) writing down failed bank real estate loans to current market values

      Market confidence comes with transparency,disclosure and prudent assumptions (yes Mr Brown) and no silly giveaways (yes Mr Osborne)

      The market will deal with the UK’s unwillingness to face harsh truths over the course of the summer,I fear.

  7. Mr.Kowalski says:

    Notay: ““If this was happening in the US, Bernanke would’ve squashed this bug a week ago”

    That was actually me, and it was in reference to the aggressiveness of Bernanke as compared to the ECB/EU to act promptly and forcefully in a crisis. As to the situation here in the states, I’ll say our situation isn’t much better than our cousins across the pond; our day is coming, bet on it. But I have to say that I think EUtopia’s day will arrive a tad sooner; the EU banks are a complete catastrophe (at least the Irish are admitting this up front) and the messes in Spain & Italy will come before ours does. If the Euro does’nt make it, they’ll likely take down the world’s financial system with it. Ultimately, thanks to the invention of the credit default swap and the parting of any semblance of common sense in lending worldwide (we’re the worst bar none here) with the ensuing catastrophic bank leverage ratios, we’re all in the same economic pleasure craft.. and just above that gaping hole in the port bow is the word Titanic.

  8. DanielC says:

    I’ve never quite figured out why these “bad loan banks” were helpful. If they take loans off of the troubled banks at approximately fair value (i.e. they’re not actually a subsidy or stealth capital infusion in drag), which is presumably what the loan ought to have been carried at or ought to sooner or later been written down to, then the transaction is neutral w.r.t. the troubled banks’ solvency, even if it improves their liquidity. Is liquid-insolvent better than illiquid-insolvent? (non-rhetorical question)

    Sooner or later the bad loans have to be earned out, written off, foreclosed, etc – is there any reason to expect that this will be handled any better by some sort of centralized “bad bank” than it would be by the banks who wrote the loans in the first place?

  9. Mr.Kowalski says:

    California will simply have to make due with budget tricks, tax hikes and slashing state employee expenditures. I spoke to one lady who works for the Governator’s environmental advisory group; she’s saying state employees are taking stiff pay cuts and that they’re shutting down prisons. There are protests daily at state universities (Berkeley especially) about the stiff increase in tuition because of budget cuts. But always remember that this stuff is nothing compared to what happened during the Depression. Ambrose’s fabulous article describes the America that FDR inherited: http://www.telegraph.co.uk/finance/comment/ambroseevans_pritchard/4339501/Bad-news-were-back-to-1931.-Good-news-its-not-1933-yet.html

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